Do higher interest rates raise or lower inflation? To any undergraduate student studying economics or finance, the aforementioned question is "ECON 101." If you are a journalist at The New York Times, Bloomberg or The Wall Street Journal, or just a regular layperson, you too might give the standard, century-old answer to such a question. Surely higher interest rates lower inflation and lower rates raise inflation, right? In the post-Great Recession period we live in, all bets are off. This is not your grandfather's economy, and the "new normal" means old theories may no longer hold.
Last month, John H. Cochrane, the world-renowned professor of finance at the Booth School of Business in the University of Chicago updated the answer to this question from a post-2007 perspective. Cochrane literally wrote the book on asset pricing, with a textbook of the same name, and is a giant in the field of finance. He sits on a faculty of Nobel laureates and is widely-regarded as a future Nobel laureate himself. In Cochrane's February 2016 paper titled "Do Higher Interest Rates Raise or Lower Inflation?" Cochrane basically answers no. He starts the paper by saying, "The evidence for lower inflation is weak," and spends 96 pages proving why higher interest rates do not curb inflation.
Federal Reserve President James Bullard echoed Cochrane's theories citing his work in a presentation Friday in Frankfurt. Bullard, the CEO of the St. Louis Federal Reserve Bank (Fed), outlined the case for a fresh look at outdated economic theories that no longer predict inflation post-2007. A "low interest rate" period, Bullard argues, "eventually puts downward pressure on inflation." Bullard points out that he too incorrectly believed the old theories. He said these new theories "contrast sharply with conventional wisdom and central bank rhetoric, including much of my own." So why is it that Turkey and much of the global economy believed that a "zero-interest rate period is putting upward pressure on inflation and offers the best hope for returning inflation to target?" Well, old habits die hard.
President Recep Tayyip Erdoğan has repeatedly theorized that indeed higher interest rates will not cause lower inflation and that just the opposite is true. On Sunday President Erdoğan repeated his claims in a town hall-style meeting with college students. "I realize that this causes me to oppose many, but my thesis is this: I believe that there's a direct relationship between inflation and interest rates, not an inverse relationship. If you raise interest rates, inflation will rise; if you decrease interest rates, inflation will fall."
Erdoğan is largely lauded for ushering in a period of financial discipline unparalleled in Turkey's history. Interest rates are down more than 90 percent from when Erdoğan first took office to single digits now. Interest paid on government debt is at its lowest levels in history, and despite several wars on Turkey's doorstep and near economic collapse among its primary trading partners, Turkey's economy remains resilient.
Opposition to some Erdoğan social policies have, however, caused some media outlets to exercise knee-jerk reactions to any Erdoğan proposal, including economic ones. The president's comments on the relationship between interest rates and inflation have been dismissed by many such foreign and domestic media outlets without discussing the theory. Bloomberg News, however, wrote a lengthy piece two years ago when it referred to this theory as "bunk." The piece quotes Paul Krugman who dismisses the "neo-Fisherian" ideas as not to be taken "seriously." Of course, Krugman is most famous, perhaps, for his visionary quote: "By 2005 or so, it will become clear that the Internet's impact on the economy has been no greater than the fax machine's." While egos abound in both politics and academia, Krugman's is perhaps incomparable, and the inability to entertain any new economic theory - or the potential implications of any new technology - is not a luxury policymakers should have. It's Krugman's right to dismiss Bullard and Cochrane, however, Cochrane's new paper is backed by hard data. While it remains to be seen if neo-Fisherian models fit economies in emerging markets and Turkey's, dismissing them or any economic theory based on political opposition is irresponsible and dangerous.
The recent renewed interest in neo-Fisherian theories may well vindicate Erdoğan's economic thesis. Perhaps the most critical lesson here is that unlike Krugman, we should not fear new technologies or new theories and instead work toward solving today's problems with the tools of tomorrow.
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